Easy Street

How Money Market Funds Were Wounded by European Interest-Rate Cuts

Marketplace Contributor Jul 6, 2012

While the U.S. slumbers through a lazy pseudo-holiday weekend – July 4th having landed, inauspiciously, on a Wednesday – the European debt crisis may be approaching our shores.

Bloomberg News has reported over the past two days that several large financial firms – including Goldman Sachs and JP Morgan – are stopping their investments in some of their European money-market funds. Investors will still be able to pull their money out of those funds, but won’t be able to do much more with those financial products.

The reason is a little haunting. This week, the European Central Bank cut its interest rate for deposits to 0%. Money market funds make their money, in part, on interest rates.

That means that, once you include fees and the rest, investors in money markets are actually losing money. This is not like other funds losing money – when money market funds lose money, it’s a sign of a financial crisis afoot. Money-market funds don’t pay investors very much; they take very little risk and offer very little return.  That’s because the entire goal of money market funds is to have a stable value of $1 a share. If the money market’s value falls below $1, then it “breaks the buck.”

And breaking the buck would be a disaster. It is very rare – in fact, it only really happened on a wide scale during the 2008 financial crisis – and it spurred the market panic that later brought down Lehman Brothers.

Bloomberg has a nice little explanatory note from Goldman:

“The European market environment is in unchartered territory with such historically low — or even negative — yields for high-quality issuance,” Goldman Sachs (GS) said in a memo to fund shareholders, citing the ECB’s rate cut. “It is not currently feasible for our portfolio managers to deploy capital without substantially diluting the yield for the existing base of shareholders.”

Translation: with interest rates this low, the portfolio managers in charge of these funds don’t see the point of even trying anymore, at least in European funds.

To add a dark note here, it’s unclear right now whether the banks have a legitimate concern or whether they are doing this out of sheer bloody-minded pique with the European Central Bank.

After all, the major effect of the ECB’s rate cut on July 5 was to make it unprofitable – in fact, punishing – for banks to park their dollars with the central bank. The ECB wants the banks instead to invest those dollars, to lend them out to companies and people. 

And the banks are thinking,  in response, “you can not be serious.” After all, there’s a quiet credit crisis underway. Reports are the banks know they don’t have enough money on hand to carry them through another big financial crisis. As a result, the prevailing financial  psychology calls for hoarding money. 

It doesn’t help that the rate cut does, indeed, make the money-market funds nearly unprofitable to run – in a time when banks are really suffering and more desperate than ever for profits.

So, if one is a conspiracy theorist, this may be a good time to build a case for the claim that the banks are trying to lash out at the ECB with a bold statement. In other words, they may be taking out their frustrations with the ECB rate cut on money-market funds.

If so, they are making a definitive statement. This isn’t just whimpering. These money-market fund closures are significant.

JP Morgan’s closed funds alone – with $29 billion in assets, according to Bloomberg – account for 22% of all money market funds that invest using euros. Goldman Sachs’ most recently closed fund – the Goldman Sachs Euro Government Liquid Reserves Fund – was 1.4 billion euros in size and had investments in French government bonds, a continent-wide European bailout fund, and a couple of banks.  (To be fair, however, money markets are designed to invest in short-term debt and the maturity date of many of the bonds in the fund’s portfolio was drawing near – many in July and August. So it’s not like that particular fund was cut down in the prime of life.)

So, let’s telescope out for a second. Who cares if some banks want to cut back on money market funds?

Actually, we should all care.

The world’s financial system is heavily dependent on money market funds. Money markets act as short-term lenders to banks, governments and other crucial institutions. And we’ve seen what happens when money markets become unstable: in 2008, investors in money market funds started panicking after Lehman Brothers fell, and created a deeper panic.

So, this isn’t good news for the financial system. These European money-market funds make significant investments in European banks and European countries.

Without their support, the banks, countries and the European bailout fund may have to scramble to find other places to get money. That comes at the worst possible time. Global investors are already abandoning European investments to shift money into Treasury bonds.

This may end up being a dark irony of the European Central Bank’s interest rate cut.

The cut in the interest rate was meant to convince banks to stop parking money, to lend more, to get more money into the system and make it more stable – in Wall Street parlance, to add “liquidity.”

But the backlash from banks shows that they’re willing to close money market funds rather than lose profits. The effect, ironically, is to reduce liquidity in the financial system.

Right now, the euro crisis is so habitually low-key – a slow-motion disaster – that this issue with money market funds is no bigger than just some smoldering charcoal. But if something occurs to panic investors about the stability of banks, the pullback in European money market funds could end up being the pit of a five-alarm fire.

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